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Circle, or square?

September 1, 2006


Ron Wirtz Editor, fedgazette

The challenges that face anyone trying to measure nonprofits—in any dimension—underlie a fundamental question that economists and other researchers are still trying to get their hands around: Can the measuring sticks traditionally used on the for-profit economy be effectively applied to nonprofits?

David Renz, director of the Midwest Center for Nonprofit Leadership, claims some researchers are trying to "fit a square in a circle" when nonprofits are treated like for-profit firms. "Some things of the nonprofit economy are so consistent with the economy at large" that it's easy to think there are easy comparisons between the for-profit and nonprofit sectors, says Renz. That impression, he contends, is inaccurate. "There are certain facets of the nonprofit economy that are fundamentally different," and the best research sheds light on the economically unique elements of nonprofits.

It might help to try to understand what differentiates nonprofits from for-profits and government. Generally speaking, for-profits provide services or goods where there is a profit to be made. Public goods and services, that is, things like national defense that are nonrival (consumption by one does not reduce consumption available for others) and nonexcludable (citizens can't be legally prohibited from consuming them) are provided by government.

What's left over—a broad and diffuse collection of (mostly) services, with few clear boundaries or rules—is largely given over to nonprofits. Where nonprofits excel, according to academic sources and existing research, is in serving minority and/or marginalized constituencies. If that sounds squishy, it is. There is very little in the literature distinguishing exactly how certain nonprofit goods like hospital beds are different from the same beds in public or private hospitals.

What really sets nonprofits apart is the role of a mostly invisible third-party payer, who buys down the cost of a service when it is unaffordable, because either the customer is poor or the service is too expensive for anyone but the well-heeled, according to David La Piana, president of a California consulting firm to nonprofits. Third-party payers are government, foundations and individual donors "who do a most un-economic thing—they pay so someone else can receive a service," thereby creating two sets of nonprofit constituents: customers who use a nonprofit service and third-party payers who subsidize the service, said La Piana. "All sorts of mischief—and creativity—comes from this situation."

It also introduces the economically squishier realm of organizational motivation. The profit motive is well understood when it comes to for-profits. Nonprofits have no similar incentive to maximize revenues or profit. That's where mission comes in for nonprofits. It replaces a financial motive with a social-outcomes orientation; it's typically a noneconomic goal that nonetheless has very direct economic effects on the organization.

"It is hard to overstate the importance of mission in shaping the economic study of nonprofits. Mission attracts entrepreneurs, employees, donors, and volunteers," write economists Al Slivinski of the University of Western Ontario and Eleanor Brown of Pomona College, authors of a chapter in a soon-to-be published book on nonprofits. Mission can lead to struggles among organizational stakeholders—donors as well as paid managers—who see different operational paths to achieving the nonprofit's goals. Mission is also the policy rationale for exempting nonprofits from a variety of government taxes and for making charitable contributions tax-deductible—economic incentives that (combined with the ease of registering a nonprofit with the Internal Revenue Service) are believed to be a driving force in the growth of nonprofits.

Mission and the lack of a profit motive are also believed to prompt nonprofits to behave differently than for-profits, even in the same field. For example, much is made of same-sector competition among nonprofits and for-profits, like banks versus credit unions, or nonprofit hospitals versus for-profit ones. For-profit enterprises complain that nonprofits act just like them, but with tax exemptions that give them an unfair competitive advantage.

Prevailing research, however, says nonprofits don't necessarily act the same as for-profits. Mark Schlesinger of Yale University and Bradford Gray of the Urban Institute published a study last year that looks at several hundred empirical studies of nonprofit and for-profit health services. Schlesinger and Gray conclude that form of ownership does affect the accessibility, quality and cost of services. For-profits had larger price markups, while nonprofits adopted more trustworthy practices and served as incubators for new health services, but were also slower to react to changing conditions. The authors say nonprofits played a "vital role" in influencing the practices of their local for-profit competitors.

Similarly, Slivinski and Brown argue that "it seems clear that nonprofits behave differently from for-profit firms. ... Nonprofit firms are not, in general, for-profits in disguise. Neither are nonprofits easily categorized as muddle-headed bastions of ideology that, freed from stockholder oversight, waste resources with flagrant disregard for market signals of value and scarcity."

Mission and lack of a profit motive also play a role in consumer choice in markets with both nonprofit and for-profit providers. Where consumers lack adequate information and quality is hard to observe, consumers often opt for nonprofit providers because they fear being price-gouged or otherwise mistreated by for-profit firms. Child day-care centers and nursing homes are two examples of what economists call "trust goods."

But this argument offers a rationale for nonprofits to be involved in markets for virtually any good and service since rarely is there perfect consumer information. With this rationale, nonprofits should be proliferating in the used-car sector.

Ronald A. Wirtz

Return to: The Hidden Economy of Nonprofits

Ron Wirtz
Editor, fedgazette

Ron Wirtz is a Minneapolis Fed regional outreach director. Ron tracks current business conditions, with a focus on employment and wages, construction, real estate, consumer spending, and tourism. In this role, he networks with businesses in the Bank’s six-state region and gives frequent speeches on economic conditions. Follow him on Twitter @RonWirtz.